We are being led by imbeciles

After yesterday’s marathon blog, today will be easier going (and shorter). I was reading John Maynard Keynes recently – circa 1928 – that is, 8 years before the publication of the General Theory with his Treatise on Money intervening. He was railing against the principles and practice of ‘sound finance’, which he noted had deliberately caused billions of pounds in lost income for the British economy. He urged the Treasury and the Bank of England to abandon their conservative (austerity) approach to the economy and, instead, embark on wide-scale fiscal stimulus to create jobs and prosperity. He concluded that with thousands of workers idling away in mass unemployment that it was “utterly imbecile to say that we cannot afford” to stimulate employment via large-scale public works – building infrastructure etc. He considered the policy makers who opposed such options were caught up in “the delirium of mental confusion”. The stark reality is that 88 years later, he could have written exactly the same article and would have been ‘right on the money’. We are being led (euphemism) by imbeciles.

In December 2015 compared with November 2015, seasonally adjusted industrial production fell by 1.0% in both the euro area (EA19) and the EU28 … In November 2015 industrial production fell by 0.5% in both zones …

Among Member States for which data are available, the largest decreases in industrial production were registered in the Netherlands (-9.4%), Estonia (-8.8%) and Germany (-2.3%) …

Which means that the overall monetary union is back in recession if industrial production is considered.

The other point to note is that the dominant neo-liberal narrative in Europe (and elsewhere) in relation to the ongoing consequences of the GFC focuses on individual nation failings – such as, lack of competitiveness, excessive wage rates, excessive regulation, etc – and the need for so-called ‘internal devaluation’ as a way of restoring ‘competitiveness’ and structural reform aimed at boosting productivity.

The problem with this narrative is that it is hard to maintain when industrial production is falling across a number of nations including Germany and the Netherlands, which are meant to be competitive leaders in the Eurozone.

The structural ‘reform’ agenda seems very transparent when confronted with this type of reality. Its aim is to redistribute national income in favour of capital and force workers to labour longer and harder for less reward. The European Commission is, after all, a branch of corporate power.

On July 31, 1928, John Maynard Keynes wrote a short article in the Evening Standard entitled – How to Organize a Wave of Prosperity. I have created a PDF version of the article because it is not easily assessable to those without expensive library subscriptions.

The context was the slowdown in British industry in that year and the subsequent rise in mass unemployment.

Keynes wrote:

Moreover, the more successful the efforts which are being made to restore the margin of profits by ‘rationalisation’, the greater the likelihood – at first anyhow – of increasing unemployment.

And the more successful the efforts of the Treasury, in the pursuit of so-called `Economy’, to damp down the forms of capital expansion which they control – telephones, roads, housing, etc., again the greater the certainty of increasing unemployment.

The resonance with contemporary events some 88 years later is frightening.

Keynes wrote that the “fundamental blunder of the Treasury and of the Bank of England has been due, from the beginning, to their belief that if they looked after the deflation of prices the deflation of costs would look after itself.”

He also said that “an assault on wages is … maladroit, because the wage rates which will be most likely to yield before the assault will be those in which wages are already relatively low because of bargaining weakness.”

He also eschewed “rationalisation” – corporate and workplace restructuring etc because it worsened unemployment.

His preferred approach was to use policy to ensure that “plant and productive resources” were working “to a hundred per cent of capacity”.

This would help industry “afford the higher wages” and reduce unemployment (the “wastefulness of plant employed 10 or 20 or 30 per cent below capacity is extreme”).

But restoring full employment after a recession:

… lies entirely outside the power of individual business men to take the initiative. The first steps can be taken only by the Bank of England and the Chancellor of the Exchequer. Yet the consequences of their policy so far has been to ensure that businesses shall be unprofitable and that the level of unemployment shall not fall below the million level.

He wanted the Bank of England to ensure banks had reserves to back their lending activities if they could not get them elsewhere – so an aggressive ‘lender of last resort’ facility.

Moreover, he said that:

… the Chancellor of the Exchequer must remove and reverse his pressure against public spending on capital account.

Every public department and every local authority should be encouraged and helped to go forward with all good projects for capital expansion which they have ready or can prepare – roads, bridges, ports, buildings, slum clearances, electrification, telephones, etc., etc.

That is, a large-scale fiscal expansion.

He finished with his classic assessment of the resistance to using fiscal policy in this way:

When we have unemployed men and unemployed plant and more savings than we are using at home, it is utterly imbecile to say that we cannot afford these things. For it is with the unemployed men and the unemployed plant, and with nothing else, that these things are done.

To have labour and cement and steel and machinery and transport lying by, and to say that you cannot afford to embark on harbour works or whatever it may be is the delirium of mental confusion.

Classic!

Marx, before him, had noted that it was an indecency of capitalism that when there was overproduction (deficient spending) it was the producers (the workers) that could not access the means of subsistence (wages).

Keynes even articulates the view that the Treasury and Bank of England, through their devotion “to the timidities and mental confusions of the so-called `sound’ finance”, have deliberately “reduced the wealth of the country by not less than £500,000,000”.

The other resonating fact is that Keynes wrote:

The nature of the error committed will never be exactly understood by the public.

Things have not changed much. We are once again in the thrall of ‘sound finance’ which Keynes so long ago demonstrated was damaging to the prosperity of the nation and only imbeciles would believe in it.

It also indicates that the journalists who wrote the article need to rethink their understanding of the material they write about.

Part of the ‘sound finance’ dogma pertains to the superiority of monetary policy as a counter-stabilisation tool – that is, a tool to ensure spending fluctuations are minimised and growth and employment remains strong.

The UK Guardian article reports that:

China’s central bank has stepped up action to bolster its cooling economy by loosening the rules on banks’ cash reserves in the hope that they will offer cheaper loans.

By cutting the reserve requirement ratio (RRR) – the amount of cash that banks must hold as reserves – the People’s Bank of China has in effect injected $100bn (£72bn) of long-term cash into the economy, experts said.

This is the fifth cut since last year, in addition, to cuts in short-term interest rates – the rate at which banks lend to each other.

Further, who are these ‘experts’? One is mentioned – a person who works for the “Economist Intelligence Unit” – which is a British company that in its own words helps ” businesses, financial firms and governments to understand how the world is changing and how that creates opportunities to be seized and risks to be managed”.

Might they be advised to sort out their own understanding of the basics of the monetary system first.

Let us be clear.

Lowering reserve requirements will do very little if anything to encourage bank lending in China or anywhere else.

This is the same sort of nonsense that has led central bankers to introduce negative interest rates in the hope that imposing a tax on bank reserves in the middle of a recession will mysteriously lead banks to lend more despite the fact that their are not too many borrowers knocking on their doors for funds – such is the stagnant state these policy makers have created.

There are many reasons why relaxing reserve requirements will not suddenly stimulate more bank lending.

First, the reality is that the reserve requirements that might be in place at any point in time do not provide the central bank with a capacity to control the money supply.

In the real world, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank if it is short of reserves (requirements or not).

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

Bank lending is not reserve constrained. Rather, limits are placed on banks by their capital.

There is a fundamental difference between capital adequacy requirements on banks in a regulatory framework and reserve requirements. The two sorts of rules are quite distinct but are often conflated by those who do not know how the monetary system operates.

Banking regulation (capital adequacy) is now up to the Basel III framework.

The general approach of the Basel framework is to express a bank’s capital relative to its risk. Capital is divided into Tier I Capital (contributed equity plus retained earnings) and Tier II Capital (preferred shares and a proportion of subordinated debt).

The risk is expressed in terms of risk-weighted assets, which range from cash and government bonds (zero weighted) to 100 per cent weighted riskier loans etc.

Capital requirements place a limit on the leverage ratios that banks can run with and thus attempt to limit risk-taking. They also constrain the size of the banks because capital is costly. Finally, they reduce the public-private partnership ratio inherent in any banking system where governments will bail out the depositors in event of failure. The higher the capital held against its assets the more the shareholders are exposed to bank failure.

Different nations compute bank capital differently.

The main motivation of the capital adequacy regulations was to limit the bank’s capacity to originate loans and providing incentives for them to increase their capital.

The initial flaws in the approach was that the risk-weighted ratio could be increased by increasing capital (the numerator) or reducing assets (denominator). The latter could be achieved by balance sheet restructuring which is exactly what banks did.

The resort to capital arbitrage (for example, securitisations) was one major way banks could get around the capital adequacy rules.

Basel III attempts to deal with those sorts of evasion.

Lending limits are defined as a multiple of a bank’s capital. So the fundamental principle is that bank lending is capital constrained under this regulatory framework despite the devious ways banks have been able to evade the rules or the laxity of enforcement of the rules in certain nations.

But reserve requirements place no such limit on lending.

Commercial banks hold reserve accounts at the central bank for the sole purpose of facilitating the payments system (clearing house). Many countries have no reserve requirements other than the accounts must not be in the red on a sustained basis.

Reserve requirements are an artifact of the old gold standard and are irrelevant in the current monetary system. They do not reduce bank risk nor do they comprise a buffer that can be drawn on when there is a run on a bank.

To understand why reserve requirements do not constrain lending you have to understand how a bank operates. Banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).

These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these horizontal transactions will not add the required reserves.

In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the ‘discount window’. There is typically a penalty for using this source of funds.

At the individual bank level, certainly the ‘price of reserves’ may play some role in the credit department’s decision to loan funds.

But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.

1. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements.

2. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

3. Any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the ‘penalty’ rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.

4. It is the Basel capital requirements that place a limit on the expansion of a commercial bank’s balance sheet at any point in time.

The other point in relation to China at present is that bank lending remains relatively robust anyway and it is a fraught growth strategy to rely on on-going private credit buildup to sustain activity.

If China wants to ensure it maintains strong economic growth rates then it might invest more in poverty alleviation in the regional areas – and rely on the increased incomes to drive domestic demand.

Hoping that monetary policy will deliver stable growth is a pipe dream.

On the same theme, there was an article in the Australian newspaper The New Daily yesterday (February 29, 2016) – Central bank bosses are failing us – which talks about “Decades of faith in ‘monetarism’ made central bankers sure they knew how to restore global growth. It isn’t working, but there’s one more lever to pull’.

The article segues off the recent statements by former Bank of England governor Mervyn King who has criticised the blind faith in ‘monetarist’ doctrine.

The journalist argues that:

Eight years after the GFC, it’s clear that the decades-long belief in monetarism has been stretched to breaking point.

Cutting interest rates to very low levels, or to zero, or even artificially creating ‘negative interest rates’ has failed to stimulate the world’s developed economies as they were supposed to.

I helped him with the story yesterday and he quoted me as saying that “Monetarism” was “ideology, never founded in fact”.

He also wrote that:

After 2008, says Mitchell, it was the huge and coordinated use of fiscal policy around the world that actually produced renewed economic growth, not ultra-low interest rates. The China stimulus, for instance, sent Australian hard commodity prices through the roof and ‘saved’ Australia.

And yet by 2012, even in Australia, the “ideology” of monetarism regained the upper hand – the benefits of fiscal intervention were overlooked as media attention focused on the ‘debt and deficit’ problem that stimulus splurge had created.

I would be a fool not to agree 100 per cent with that (-:

And just like Keynes warned 88 years ago:

… the elected faces in Canberra – as opposed to the unelected central bankers they appoint – are virtually barred from fiscal stimulus by the powerful, monetarist narrative of ‘debt and deficit’ and ‘living within our means’.

What a sorry state the world is in!

Conclusion

Keynes warning was prescient at the time and remains a robust understanding of the causes of mass unemployment and the best policy cures.

He was fighting against ‘sound finance’ then and by the end of the Second World War had won the battle and the world entered a marvellous period of full employment and income growth with diminishing inequality and poverty.

But the conservative ideology is like a cockroach – hard to get rid of. And for the last three or so decades the world has been mired in its imbecilic nostrums that culminated into the GFC.

Rising poverty, mass unemployment and all the related ills are back – and we are too stupid to see these leaders for the imbeciles that they are!

24 Responses to We are being led by imbeciles

There was a time when the two sides or politics at least had the decency
to work from different a priori positions. Sadly, the “reformist” parties
seem to have lost the initiative. They no longer “crash through or crash”
with innovative social programmes, rather they ape the conservatives with
a “Tory-lite” approach.
However, on a positive note,the level of US grass roots support for Donald and
Bernie may demonstrate a public recognition of the limitations of the currently
“enframed” debate. While I’m tipping a victory for Hillary this time, it may be
the case that we are at “the end of the beginning”.

“It is the Basel capital requirements that place a limit on the expansion of a commercial bank’s balance sheet at any point in time.”

Probably worth mentioning, before people get the wrong end of the stick, is that loans not only create deposits, but that increase in deposits increases the demand for bank capital from depositors looking for a higher return (not just bank capital, but all capital assets).

So aggregate bank lending increases the capacity of the system to buy bank capital. Bank capital is always available. It’s just a matter of what price.

Limiting the leverage ratio just puts up the price of lending. It’s doesn’t reduce the capacity of the system to supply lending *at that price*.

If you have a system that relies upon private lending to maintain aggregate demand you have two things fighting in opposite directions – ‘capital requirements’ which put up the price of lending and lax aggregate demand which requires a cheaper price of lending.

100% reserve ideas are simply 100% capital buffers – which then requires somewhere else for the deposits generated from government spending to go. Hence the push for government bonds as ‘safe assets’.

Typically the Krugmanesque New Keynesians have gone for the half way house gesture – a larger capital buffer and a bit more bond issuing on the side. As though that controls anything in banking.

During the worst years of the Great Depression, a sad little song made the rounds of the work camps and the unemployed riders of the rails:

“Sing a song of plenty, a planet full of fools
Everybody starving by sound financial rules;
The shops were full of good things, the factories likewise,
The Banker shut his books and said ‘We must economize!’”

Very good explanation, probably very close to be fairly comprehended by anyone. Maybe even journalists could understand it.
Exemplary short, only seven pages and 3000 words. ;)
In today’s short attention span newspapers many have maximum length on articles as short as 400 to 800 words, “lengthy” articles maybe 800 to 1500.
So how to cut it down to the bare bone and get it out and have a chance to be common knowledge? A good journalist could do it, but do they think its news worthy?
And how to get it down to ~500 characters (including spaces) and spread the word in the word of comment fields?
Many of the commenters here do help to get these things expressed in a compressed way.

You say “Lowering reserve requirements will do very little if anything to encourage bank lending in China or anywhere else.” That isn’t the view of the Bank of England. They claim that keeping commercial banks short of reserves tends to raise interest rates. See p.295, para starting “Banks will typically…” here:

Of course the above ploy only works, far as I can see, where banks are near the minimum stock of reserves they need to settle up with each other. In the present climate, where banks have a huge excess stock of reserves (at least in the West – I’m not sure about China) then a small change to reserve requirements would have no effect.

Amid all the accusations that Hillary Clinton is not an honest or authentic politician, that she’s an endless shape-shifter who says whatever works to get her to the next primary, it’s important not to lose sight of the one truth she’s been telling, and will continue to tell, the voters: things will not get better. Ever. At first, I thought this was just an electoral ploy against Sanders: don’t listen to the guy promising the moon. No such thing as a free lunch and all that. But it goes deeper. The American ruling class has been trying to figure out for years, if not decades, how to manage decline, how to get Americans to get used to diminished expectations, how to adapt to the notion that life for the next generation will be worse than for the previous generation, and now, how to accept … low to zero growth rates as the new economic normal. Clinton’s campaign message isn’t just for Bernie voters; it’s for everyone. Expect little, deserve less, ask for nothing. When the leading candidate of the more left of the two parties is saying that — and getting the majority of its voters to embrace that message — the work of the American ruling class is done.

I suggested above that changing reserve requirements has little effect where banks have a large excess stock of reserves. That large excess stock can of course be very quickly disposed of by a large increase in the minimum reserve requirement. I conclude that changing the reserve requirement can be an effective way of raising interest rates even given the large stock of reserves that banks currently have.

Keynes has an interesting turn of phrase when he says, in the Evening Standard article, that the Treasury harbors the belief that “if they looked after the deflation of prices the deflation of costs would look after itself”, which he almost repeats, word for word, around 5 years later, 1933, on a radio program with J C Stamp — “Look after … unemployment and the Budget will look after itself.” He was attacking the Chancellor of the time, Stanley Baldwin, and, indirectly, the Treasury.

How true, and how disappointing that present analysts don’t seem to get this seemingly elementary point, with the British Treasury still seeming to prefer the 1920s mindset they had at the time. There is no indication that they will change their attitudes any time soon, even with the retirement of Macpherson. The OECD and the IMF, neither bastions of sound macroecon thinking, have both contended that austerity, even in the Eurozone countries, should now cease, even in the face of their advocacy of it for years. Neither Osborne nor Germany seem to be interested in following this advice.

I neglected to mention that when Osborne indicated that he “wasn’t for turning”, in a response to the OECD and IMF, uttered the imbecilic phrase that he has uttered before, contending mindlessly that Britain has to “live within its means”. Anyone could be forgiven for thinking he was a cretin. A comic strip couldn’t do justice to this.

@larry
“I neglected to mention that when Osborne indicated that he “wasn’t for turning”, in a response to the OECD and IMF, uttered the imbecilic phrase that he has uttered before, contending mindlessly that Britain has to “live within its means”. Anyone could be forgiven for thinking he was a cretin.”

Except Osborne is not a cretin (however much we would like to call him one). I can’t imagine he doesn’t understand that he could spend fiscally if he wanted to. I don’t think that he believes ‘live within its means’ in anyway applies to the UK government’s capacity to spend. He is, however, ideologically committed to shrinking the state. ‘Living within your means’ is a very powerful cover for dismantling the post www2 welfare state. And Osborne will u-turn on spending cuts, like he did in 2012, if politically necessary. And it is this 2012 u-turn on spending when recession threatened that tells me he doesn’t believe that the government’s budget is in anyway synonymous with a household budget.

Nell, he will u-turn only when his cuts hurt the “wrong people”, that is, those for whom the cuts show up in GDP figures. If the cuts don’t thus show up, he will continue to cut. He has done this throughout. Or unless here is a great outcry, as with the tax credits – but they are coming regardless, as they don’t hurt the “wrong people”. So committed is he to this shrinkage that he makes stupid errors. I didn’t actually call him a cretin, only that one could be forgiven for thinking him one. Having said that, it is difficult to know what he actually thinks. I know that he thinks Duncan Smith is an idiot, as he claimed that Smith didn’t understand his own numbers and thought he should be sacked. But such a move isn’t in Cameron’s game plan, which as far as I can see is to become a clone of Tony Blair.

We can’t really know. When we use the term ‘Osborne’ this is really ‘metonymy’ for Osborne’s advisers who tell him what to say and write his speeches and decide on the language framing including dishing out the memes such as “we’re living beyond our means” (in reality: “we’re living within our memes”). The ‘skill’ of politicians is simply to read and parrot out the words of these advisers and give interviews parroted said guff whilst preparing for the questions in advance and making sure there aren’t awkward ones.

Interesting reading, thanks Bill. I’m trying to understand his writings, but I am no economist!

Was it not the case that fiscal policy in 1928 was encumbered by the gold standard, which the BoE had not abandoned until 1931? When Keynes wrote:

“Secondly-since this would greatly reduce and perhaps avoid altogether the risks of the
experiment-the Governor of the Bank must induce his colleagues throughout the world to
change their tune when he changes his, instead of his encouraging a general deflationary
atmosphere by insisting on every state bank in Europe locking up its gold against note
issues which do not need it.”

Was he specifically advocating against the gold standard in this paragraph, for the UK and the rest of Europe? Seems to me that would be a necessary condition to fully exercise fiscal policy to achieve full employment.

The fiscal constraints do seem absurd and it frustrates me that more of the population can’t see what’s happening here. Nowadays we have fiat currency, but policy makers in the US still tell us we are constrained by a “debt ceiling” which is an artificial spending limit that was put into place by the same policy makers! So if the law isn’t working, change the darn law!

Please see “the seven deadly innocent frauds of economic policy” by Warren Mosler.
There is a recent youtube video where he appeared in Berlin to give a short presentation (50 mins) on these.
Most enlightening … and entertaining.

ありがとう、メリアさん。
Yes, I’ve read Warren Mosler’s 7 Deadly Sins some time ago, so will re-read, but it was Neil’s last three paragraphs that lost me I’m afraid.
I’m indebted to Neil for arousing my interest in MMT via CiF at the Guardian at least 2 or 3 years ago, and generally find him a good and concise communicator, but now and then his pithy posts require some prior in-depth knowledge which I feel I lack, hence the, not entirely tongue in cheek, Dummies suggestion.

Simonsky, nice one. Need to analyze the framing metaphors in order to better see where the discourse is going. Dawkins did not invent the term “meme”. See William Durham’s Coevolution to see where it might have come from. D liked it because it both rhymed with “gene” and seemed to provide a similar sort of analytical unit.

Randy Wray, who’s worked of the with Bill often, wrote an MMT Primer a few years back over at the New Economic Perspectives web site. The book has been published but also appears as it was written out under an “MMT Primer” tab at that website. It starts with the very basics, but goes much further. Probably would make a good undergrad text.

The government policy for austerity has caused unemployment, but the main reason in the future will be the advancement of technology, where robot’s will take over automated jobs. so full employment can not be achieved like the good old days. We have to look at life a different way and understand we humans have a lot more to offer, then just doing repetitive jobs.

Thanks Benedict@Large, I bought it when it was published, and am afraid to say it is still languishing unread on my bookshelf, along with a multitude of other books i would have read had I not been perusing internet blogs!

I worry that the immediacy of the internet has somehow changed our brain chemistries, so that we increasingly require the instant hit of current news, and that swallows up the time that could be devoted to general background reading, and of actual ink on paper.